Investment statistics and analysis

Incentives for attracting foreign direct investment: An overview of OECD work

The OECD has produced a considerable amount of analytical work addressing the issue of incentives for attracting foreign direct investment (FDI). This list, compiled in the context of a 2002 project undertaken by the Investment Committee, provides an overview of this work which is indicative, rather than exhaustive, of the large body of work undertaken by several OECD bodies in this area.

This paper, prepared by ProfessorMagnus Blomström, Stockholm School of Economics, discusses the overall pros and cons of offering FDI incentives. It argues that the use of investment incentives focusing on foreign firms is not a recommendable strategy. The main argument in support of this is that the strongest theoretical motive for financial subsidies to inward FDI tends to be external effects such as spillovers of technology and human capital, which do not follow automatically from foreign direct investment. In other words, it is not clear that FDI has an advantage over other kinds of investment. Also, the quality of the enabling environment for investment – which affects a country’s ability to attract FDI, and to benefit from it – is equally important to domestic investors. Hence, rather than proposing narrowly defined FDI policies, attractive terms to investors should be seen as part of a country’s overall industrial policy and be available on equal terms to all investors, foreign as well as domestic. Incentives should, following the same logic, focus on those activities that create the strongest potential for spillovers, including linkages between foreign-owned and domestic firms, education, training and R&D.

This report by Charles Oman of the OECD Development Centre emphasises the developmental impacts of FDI incentive policies. It observes that, while there has been a global increase in FDI incentives as barriers to investment have fallen, most incentives-based competition remains intra-regional. The report draws the policy conclusion that it can be counterproductive and very costly for a government to offer investment incentives if the “fundamentals” of the potential investment sites fail to meet serious investors’ basic requirements. In fact, many of the government that have been successful in attracting FDI are also among those that best meet the requirements for good governance. Moreover, while governments often formally justify FDI incentives with a need to steer corporate investment to poorer areas within the host economy, it appears that in practice incentives are of limited effectiveness in this regard. The report recommends a broad reform of policy-making including regulatory reform, privatisation and liberalisation of trade policies (external as well as internal) as a key element in a developing country strategy to attract FDI. It further highlights the need to raise levels of accountability and transparency to limit the risk of illicit practices developing in connection with investor attraction strategies.

This report by the OECD Centre for Tax Policy and Administration reviews various types of corporate tax incentives for FDI and debated some of the arguments that are often advanced for their use. The report considers the role of corporate taxation in a country’s tax mix, reviews the likely channels of influence of main tax incentive types and surveys empirical evidence of the sensitivity of investment to host country tax burdens. While the report stops short of policy recommendations, it nevertheless applies a cautionary view on incentives. First, it is far from clear that “general” incentives like corporate tax concessions can be used to address specific market imperfections. Second, it notes that a paucity of information in general – and not least as regards the incremental impact of tax incentives on investment decisions – makes authorities decide about tax strategies amid great uncertainty. Third, the choice of alternative tax incentives is found to be strongly dependent on specific country circumstances. For example, the findings in the report call for caution in the use of up-front tax incentives, particularly if the basic statutory corporate income tax rates in the host economy are relatively high, and if refund provisions are offered.

This paper, by Dr. Valpy Fitzgerald, Finance and Trade Policy Research Centre, Oxford University, reviews recent evidence relating to FDI incentives in the regulatory domain. The key issue addressed in this paper is whether competition between host countries on the basis of their regulatory regimes has any effect on the level and “quality” of inward FDI and whether such competition leads to a welfare loss to that country or internationally. The paper finds ambiguous evidence regarding the existence, effect and consequences of regulatory competition for FDI. Importantly, there is little systematic evidence in literature of a “regulatory race to the bottom” and, more generally, there appears to be no robust indication that environmental or labour standards are negatively associated with investment inflows. Conversely, while anecdotal evidence indicates that investors may be increasingly attracted to host countries with high social and environmental standards (i.e. a potential “race to the top” scenario), there is little solid research to substantiate this either.

This report, by the OECD Directorate for Education, Employment, Labour and Social Affairs, includes sections about the impact of FDI. The report concludes that there is no robust evidence that countries with low labour market standards provide a haven for foreign-owned firms. This finding is further supported by the fact that a sharply increasing share of FDI flows to the service sectors and affects employees with better-than-average work conditions. On the specific issue of export processing zones the report notes that national labour and industrial relation legislation is applicable to companies on the zones. However, there are some examples to the contrary, such as zones where collective bargaining and industrial action are proscribed. These zones appear to be mainly attracting investors who depend on cheap labour and move very easily to new locations. Hence, the selective lowering of labour market standards would not appear to be a sound strategy toward FDI-backed longer-term economic development.

This paper prepared for the Environmental Policy Committee’s Working Party on Global and Structural Policies provides a comprehensive literature review of the environmental implications of competition for investment. The paper takes stock of some existing evidence that a “race to the bottom”, “pollution havens” and “regulatory freeze” may be possible, particularly in certain resource intensive sectors, but concludes that systematic empirical evidence is still lacking. Some evidence is actually to the contrary. The private sector has in many cases showed an unwillingness to invest in countries with particularly lax environmental laws and standards, because the cost of environmental compliance is limited whereas the reputational cost of benefiting from low standards abroad can be considerable. Designated areas for FDI such as export processing zones do, according to the paper, rarely offer lower environmental standards than elsewhere in the host economy. In some cases they even strive toward higher standards as a way of attracting highly skilled staff.

This paper prepared for the Committee on Competition Law and Policy’s Working Party No. 2 on Competition and Regulation included sections dealing with “subsidies that affect location decisions”. The paper cautions against trying to discipline investment incentives on the grounds that a degree of subsidised-based competition may produce efficiency gains. According to this line of argument, the presence of investment incentives ensure that the jurisdiction that expects the greatest economic benefits from a given investment project is free to secure it by topping the incentives of competing jurisdictions. However, as also noted by the paper, this finding is preconditioned on firms being mobile and incentives not discriminating on the basis of nationality. Against this background the paper advocates the use of generally available investment subsidies rather than particular FDI incentives.

[CIME] A joint questionnaire exercise by the OECD and WAIPA Secretariats has assessed the degree to which developing countries compete for FDI by means of incentives, against each other and against the most highly developed economies. The paper concludes that while many developing countries engage in either proactive or defensive incentive strategies aimed at attracting FDI in competition with other locations, there are few cases of them being in direct competition with developed economies. Competition mostly occurs within geographic regions and where countries are on comparable levels of economic development, which limits the scope for direct competition between mature and developing economies. Moreover, the cases of particularly sharp competition for individual investment projects appear to be limited to a few economic sectors – notably car production.

This recent study by Andrew Charlton of the OECD Development Centre focuses on the policy concerns (and potential benefits) that arise from cross-border or cross-jurisdictional incentives-based competition. It develops a two-dimensional framework in which the discussion of potentially wasteful incentives is expanded to cover the international as well as the national dimension. The paper finds that competitive pressures between jurisdictions are in many cases a significant determinant of the generosity of investment incentive packages. However, it also observes that it is difficult to assess whether – or in what cases – the efficiency gains from competitive bidding outweigh the cost of such practices to the international system. Policy makers may nevertheless wish to put mechanisms in place to guard their jurisdictions from the possibility of sub-optimal outcomes. The paper develops a set of policy conclusions along two lines, by examining the contributions that policies of increased transparency and of a more formalised co-operation between jurisdictions can make toward minimising the downside risks.

The Harmful Impacts of Incentives Used to Attract Foreign Direct Investment: The Challenges Facing Policy-Makers, 2002
[not in the public domain]

This consultant paper prepared by Jon Church of InSites Investment Counsellors addresses a range of issues related to investment incentives from a practitioner’s viewpoint. The paper reviews a large body of anecdotal evidence from some of the most highly developed OECD countries. It argues that an increasing number of investment projects put one large investor in a quasi-monopolistic position vis-à-vis a fragmented community of host locations. Moreover, it cites a large number of representatives and investors who consider that the scale of investment incentives is presently excessive and uses this in support of the argument that they (the incentives) have reached a level where they put the efficiency of capital allocation at risk. The paper furthermore proposes some cross-country approaches that could be applied to curb “harmful” FDI incentives. It recognises the usefulness of increased transparency in this respect, but argues that co-operation between jurisdictions probably needs to be taken further. In particular, the paper argues that policy makers should seek to agree on a “statement of basic principles” on international investment policy. It proposes a series of commitments regarding international investment incentives, notably: the principle of transparency; the principle of non-discrimination (including national treatment and MFN); rolling back the offering of “the most harmful types of FDI incentives”; and refraining from using “harmful regulatory incentives”.

This policy statement by BIAC makes public views held by members of the business community. The statement observes that most companies would prefer a world without investment incentives where all competition between locations would be on the basis of the quality of enabling environments – inter alia because incentives imply a degree of discrimination among enterprises. The policy statement acknowledges a risk of fuelling an environment where FDI flows primarily to countries with “the deepest pockets” and warns again a situation in which smaller countries could be disadvantaged because of their inability to offset and absorb start-up losses from FDI. However, BIAC also notes that investor attraction depends on a complicated policy mosaic and that the focus of the discussion should therefore be much broader than the isolated issue of incentives. The following policy recommendations are proposed to national authorities as a means of safeguarding against negative outcomes. FDI incentives should be: generally available; non-discriminatory; transparent; in proportion to the expected benefits; clearly causal or closely linked with the actual investment; non-trade distorting; oriented toward long-term investment; temporary; and rooted in a coherent business model.